Asset Class Summary: 3rd Quarter 2014

Following is an overview of equities, bonds, hedge equity and alternatives, along with some illustrative charts.

Equities

Global stock markets were generally flat to down in the third quarter. In the United States, larger-company stocks ended with a slight gain, with the S&P 500 gaining 1% while smaller-company stocks were down over 7%. Year to date, large-cap stocks have gained 8% versus a decline of 4% for small-caps. Our portfolios are tactically underweight small caps—which has been helpful given this year’s performance divergence between the two asset classes. Our view is that while large-caps, broadly speaking, are pretty close to fair value, small caps look overvalued and are more vulnerable in market sell-offs. Developed international and emerging-markets stocks fell during the quarter, particularly in dollar terms as the U.S. dollar rose against other currencies. (A stronger dollar reduces returns on investments denominated in foreign currencies).

The quarter’s market returns came against a now familiar backdrop of macroeconomic and geopolitical considerations and worries. They include divergent economic outlooks around the globe, with the United States seemingly on a path of modest recovery and Europe facing stalled growth and potential deflation. China and other emerging markets continue to seek a balance between maintaining sufficient economic growth versus slowing credit growth and implementing economic reform on the other.

Geopolitical issues, most recently with the escalation of U.S. military action in the Middle East, and concern about high stock prices in the United States are other current concerns investors are weighing.  Ironically, oil prices which in times past have risen considerably during any Middle East unrest, actually fell 20% during the quarter.  This drop is a direct result of U.S. oil production reaching the highest levels in thirty years (see chart below), and acts like a “tax refund” for consumers, and driving more spending. According to the Department of Energy, every one cent drop in the price of a gallon of gasoline saves consumers $1.3 billion over a year.  Many experts are predicting national average prices to drop below $3.00 per gallon in 2015.

Shale Revolution - Q3 2014

Bonds

We have been concerned for some time about the effect of eventually rising interest rates on long-term bond prices, and have therefore been content to focus the portfolio on shorter term bonds.  When discussing interest rates, it is important to distinguish between short-term and long-term rates.  The green line in the chart below represents the “yield curve” – the difference between long-term and short-term yields.  As you can tell, when the difference is large (steep yield curve), the economy is growing.  When it is small or negative (i.e., when the Fed has raised short-term rates to combat inflation), this has usually preceded a recession.  Today the yield curve is steep, and the Fed’s new chairperson Janet Yellen has made it clear it is likely to remain so.  That suggests continued economic growth, which is healthy for stocks, and is part of why we view bonds as less attractive.

10 year Treasury yield

Hedged Equity and Alternatives

Our hedged equity and alternative holdings have historically had less correlation to the stock markets. We include them in client portfolios because of their potential to hold up better when stock market performance is down, and in some cases even make money in such an environment.

Stocks have trended higher with only minor interruptions.  That won’t continue forever, and is part of why we allocate a portion of client portfolios to hedged equity and alternative investments (see chart below).  After several years of above average returns for stocks, investors should be prepared for the possibility of more muted returns going forward.

s-and-p 500 index

Other articles that appeared in the 3rd Quarter issue of Your Family CFO Report include Economic Overview and Investment Management Please call us anytime with questions at 404-874-6244 and feel free to pass our message along to friends.

All references in this publication referring to our average allocation or “typical portfolios” reflect those of the fully discretionary accounts of clients with moderate risk profiles. Actual client portfolios are tailored to individual client circumstances and asset allocations may vary.  Any reference to returns reflect the performance of asset classes, are for illustration purposes only, and do not reflect the returns of any specific investment of Smith & Howard Wealth Management. No representation is made that any investment decisions discussed herein have been profitable in the past or will be in the future. Past performance is no guarantee of future results. A list of all recommended investments is available upon request.

Related Post